Risk Metrics
Box II: Liquidity Risk Management, Stress Tests & Capital Adequacy
Even though risk policies address the importance of managing liquidity risk actively, very few risk policies in energy firms address liquidity risk management adequately. The first step within the policies component is to form a liquidity risk strategy (funding and market liquidity) which can be translated into procedures that set out operating standards.
In order to estimate liquidity risk, companies need a framework that explicitly addresses the potential demand and supply of cash. This framework should address medium- and long-term horizons as well as the cost of liquidating positions in a stressed market environment.
Risk managers need the tools to identify scenarios that could result in liquidity shortfalls, particularly under stress market conditions. Funding liquidity risk measurement requires metrics similar to Potential Future Exposure but applied to margin and collateral calls in stress situations.
Liquidity risk management is often mistaken for ‘crisis management’, even though it is commonly the case that lack of planning often forces companies to address liquidity risk management issues only when crises occur. A liquidity risk engine that allows for stress tests based on material risk factors such as rating downgrade and/or large movement in energy and commodity prices that could prompt large cash outflows can highlight potential stress points.
Figure 5: Collateral Stress Test
considerations in the evaluation of hedging and trading strategies, as well as large acquisition and divestment decisions. Risk managers that develop the right risk metrics to assist decision makers as part of their toolkit can proactively assist with the identification, measurement and management process of those risks. With the right metrics the firm can balance
and optimise the various risk dimensions based on its own risk-reward trade-offs, and determine whether corrective action is required in the form of mitigation strategies such as insurance or hedging strategy adjustments. In order for the transformation from static
Source: NQuantX LLC
the net collateral requirements as a function of oil prices. We can see how potential collateral inflows and outflows are asymmetric for this portfolio. There could be several reasons for such pattern such as the type of collateral thresholds signed with counterparties (e.g. one-way collateral where the firm only posts collateral when it is out-of-the-money, but the counterparties do not need to post any); or maybe the firm is short options and therefore the counterparties do not need to post any further collateral.
Conclusion An effective risk management process starts with the choice
of the right metrics that capture the firm’s risk tolerance, limits and benchmarks. Rating agencies and investors are paying closer attention to the quality of the risk management process as well as the metrics being used to support that process. Collateral, Cashflow and Earnings at Risk are often key
60
portfolio measures (such as MtM and VaR) to dynamic measures such as (CFaR or EaR) to take place, systems and models must change to
capture the evolving needs of traders, risk managers and senior managers at energy firms. ■
Carlos Blanco is co-founder and Managing Director of NQuantX, LLC, a financial engineering firm that develops customized software to design and implement hedging programs and trading strategies, as well as valuation and
risk measurement of energy derivatives, long term contracts and physical assets. He also conducts several courses on
energy derivatives hedging, pricing and risk management, as well as credit and counterparty risk management for the Oxford-Princeton Program. He is a lecturer on risk management at the University of California, Berkeley. E:
carlos@nquantx.com
References
Blanco, C. and Mammarelli, C., Dynamic Risk Analysis in Energy Markets, Worldpower, 2008.
worldPower 2010
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